BANK OF BOTSWANA · Capital Measurement and Capital Standards (Basel II) as a basis for the...
Transcript of BANK OF BOTSWANA · Capital Measurement and Capital Standards (Basel II) as a basis for the...
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BANK OF BOTSWANA
DIRECTIVE ON THE REVISED INTERNATIONAL CONVERGENCE OF
CAPITAL MEASUREMENT AND CAPITAL STANDARDS FOR BOTSWANA
(BASEL II)
Issue Date: September 8, 2015
Effective Date: January 1, 2016
Directive on the Revised International Convergence of Capital Measurement and Capital Standards for Botswana (Basel II)
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DIRECTIVE ON THE REVISED INTERNATIONAL CONVERGENCE OF
CAPITAL MEASUREMENT AND CAPITAL STANDARDS (BASEL II)
Table of Contents
1. AUTHORITY, PURPOSE AND SCOPE ......................................................................................... 1
(a) Authority ................................................................................................................................... 1
(b) Purpose ...................................................................................................................................... 1
(c) Effective Date ........................................................................................................................... 1
(d) Scope ......................................................................................................................................... 1
2. THE REVISED CAPITAL STRUCTURE ....................................................................................... 2
3. MINIMUM CAPITAL ADEQUACY RATIO ............................................................................... 13
4. PILLAR I: MINIMUM REGULATORY CAPITAL REQUIREMENTS .................................. 14
5. PILLAR II: THE SUPERVISORY REVIEW PROCESS ............................................................ 21
6. PILLAR III: MARKET DISCIPLINE ........................................................................................... 21
7. ABOLISHMENT OF LIMITS AND MINIMA ............................................................................. 21
8. REPEAL OF THE BASEL I FRAMEWORK ............................................................................... 21
APPENDICES ........................................................................................................................................... 23
Appendix 1 ......................................................................................................................................... 24
(a) Summary of Risk-weights under Standardised Approach for Credit Risk ............................. 24
(b) Credit Conversion Factors: Off-balance Sheet Items ............................................................. 25
Appendix 2 ......................................................................................................................................... 26
Eligible Collateral for Credit Risk ...................................................................................................... 26
Appendix 3 ......................................................................................................................................... 27
The Legal Criteria for Netting Arrangements and Bilateral Netting Rules (Set-off Principle) .......... 27
Directive on the Revised International Convergence of Capital Measurement and Capital Standards for Botswana (Basel II)
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1. AUTHORITY, PURPOSE AND SCOPE
(a) Authority
1.1 This Directive is issued by the Bank of Botswana (Bank) pursuant to its authority set forth
in Section 13 of the Banking Act (CAP. 46:04) (hereinafter referred to as the “Act”) and
Regulation 7 of the Banking Regulations, 1995 (hereinafter referred to as “Regulations”).
(b) Purpose
1.2 The purpose of this Directive is to prescribe the “Revised International Convergence of
Capital Measurement and Capital Standards (Basel II) as a basis for the determination of
the capital adequacy requirements for banks in Botswana.
1.3 In accordance with Section 13(1) of the Act, “every bank shall maintain paid up unimpaired
capital at least equal to such percentage of such bank’s total assets as may be prescribed
for the purpose”. Furthermore, the Act empowers the Bank to set the minimum prudential
capital adequacy requirements for licensed banks in Botswana and define qualifying
components of capital, taking into account the ability of such owners’ funds and/or long-
term debt instruments to absorb losses.
1.4 While retaining the meaning of capital and unimpaired capital, as set out in Sections 13(3)
and 13(4) of the Act, the determination of eligible capital, method of computation and
composition of regulatory capital shall be as specified in the Directive on the Revised
International Convergence of Capital Measurement and Capital Standards (Basel II). This
is an abridged version of the more detailed guidelines set out in the Basel Committee on
Banking Supervision (BCBS) Basel II document (www.bis.org).
(c) Effective Date
1.5 Effective January 1, 2016, a bank shall maintain paid up unimpaired capital of at least 15
percent of the bank’s total risk-weighted assets. The total risk-weighted assets are
determined by multiplying the capital requirements for market risk and operational risk by
6.7 (that is, the reciprocal of the minimum capital ratio of 15 percent) and adding the
resulting amount to the sum of risk-weighted assets for credit risk. This new framework is
explained in paragraphs 2 to 5 below.
(d) Scope
1.6 This Directive applies to a bank licensed by the Bank under the Act, to statutory banks and
other financial institutions established under separate Acts of Parliament, which fall under
the purview of the Bank’s supervision in terms of Section 53(2) of the Act and/or their
respective statutes.
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2. THE REVISED CAPITAL STRUCTURE
2.1 The capital components, for the purpose of this Directive, shall be as set out under Section
13(3) of the Act. Additionally, consistent with Section 13(5) of the Act, the new definition
of total regulatory capital (also referred to as adjusted capital) comprises the following
elements:
Tier I Capital (Going-concern Capital)
2.2 Tier I Capital is the portion of capital which is permanently and freely available to absorb
unanticipated losses on a “going concern” basis. This form of capital, in turn, comprises
both Common Equity Tier I (CET1) Capital and Additional Tier I Capital. CET 1 Capital
is the purest and most predominant form of capital and includes common shares and
retained earnings. The new definition of regulatory capital introduces stricter criteria for
determining the constituents of Additional Tier I Capital to ensure that these instruments
can also absorb losses of a bank on a “going-concern” basis.
Common Equity Tier I (CET1 Capital)
2.3 CET1 capital consists of the sum of the following elements:
(a) Common shares issued by a bank that meet the criteria for classification as common
shares for regulatory purposes;
(b) Share premium (stock surplus) resulting from the issue of instruments included in
CET1 capital;
(c) Retained earnings, cumulative general reserves set aside as part of the appropriation
from net profit in any given financial year, including interim profits, provided such
interim profits are audited. Furthermore, any proposed dividends not yet paid
should be deducted from the retained earnings for that year;
(d) Accumulated other comprehensive income1 and other disclosed reserves;
(e) Common shares issued by consolidated subsidiaries of a bank and held by third
parties (i.e., minority interest) that qualify for inclusion in CET1 capital; and
(f) Regulatory adjustments2 applied in the calculation of CET1 capital.
1 Accumulated other comprehensive income, relating to unrealised gains/(losses) from bonds and treasury bills held as
available for sale, will not be recognised as part of capital elements, since these instruments do not form part of capital,
and therefore, any associated gains/losses from them are disqualified as well. However, gains on equity investments
should be restricted to equity investments in banking, financial and insurance entities.
2 See paragraph 4.6.
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Criteria for Classification as part of CET1 Capital
2.4 For purposes of paragraph 2.3 above, CET1 capital shall have the following characteristics:
(a) Represents the most subordinated claim in the liquidation of a bank;
(b) It is entitled to a claim on the residual assets that is proportional with its share of
issued capital, after all senior claims have been repaid in liquidation (i.e., has an
unlimited and variable claim, not a fixed or capped claim);
(c) The principal is perpetual and never repaid outside of liquidation (setting aside
discretionary repurchases or other means of effectively reducing capital in a
discretionary manner that is allowable under the relevant law);
(d) A bank does nothing to create an expectation at issuance that the instrument will be
bought back, redeemed or cancelled nor do the statutory or contractual terms
provide any feature which might give rise to such an expectation;
(e) Distributions are paid out of distributable items (retained earnings included). The
level of distribution is not in any way tied or linked to the amount paid in at
issuance and is not subject to a contractual cap (except to the extent that a bank is
unable to pay distributions that exceed the level of distributable items);
(f) There are no circumstances under which the dividend payment or distributions are
obligatory. Non-payment is, therefore, not an event of default;
(g) Distributions are paid only after all legal and contractual obligations have been met
and payments on more senior capital instruments have been made. This means that
there are no preferential distributions, including in respect of other elements
classified as the highest quality issued capital;
(h) It is the issued capital that takes the first and proportionately greatest share of losses
as they occur. Within the highest quality capital, each instrument absorbs losses on
a going concern basis, proportionately and pari passu with all the others;
(i) The paid in amount is recognised as equity capital (i.e., not recognised as a liability)
for determining the statement of financial position insolvency;
(j) The paid-in amount is classified as equity under the relevant accounting standards;
(k) It is directly issued and paid-in and a bank cannot directly or indirectly have funded
the purchase of the instrument;
(l) The paid-in amount is neither secured nor covered by a guarantee of the issuer or
related entity or subject to any other arrangement that legally or economically
enhances the seniority of the claim;
(m) It is only issued with the approval of the owners of the issuing bank, either given
directly by the owners or, if permitted by applicable law, given by the Board of
Directors or by other persons duly authorised by the owners; and
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(n) It is clearly and separately disclosed on a bank’s statement of financial position.
Regulatory Adjustments in the CET1 capital
2.5 The following items shall be deducted from the CET1 capital of a bank, subject to threshold
deductions, as outlined under paragraph 2.6;
(a) Goodwill and other intangible assets3;
(b) Advances of a capital nature4 granted to connected persons5;
(c) Deferred tax assets (DTA) that rely on the future profitability;
(d) Investments in own shares, whether directly or indirectly;
(e) Unrealised revaluation losses on investments in securities;
(f) Defined benefit pension fund assets;
(g) Reciprocal holdings in the capital of banking, financial and insurance entities;
(h) Cash flow hedge reserve; and
(i) Gains on sales related to securitisation transactions.
Threshold Deductions
2.6 Instead of a full deduction, the following items may each receive limited recognition when
calculating the CET1 capital of a bank, with recognition capped at 10 percent of a bank’s
common equity (after the application of all regulatory adjustments set out under paragraph
2.5):
(a) Significant investments in the common shares of unconsolidated financial
institutions (banks, insurance and other financial entities);
(b) Deferred tax assets that arise from temporary differences;
(c) Mortgage servicing rights6;
3 A bank may use IFRS 3 for the definition of goodwill and IAS38 for the definition of intangible assets to determine which
assets are to be classified as such and are thus deductible. 4 Defined as injection of risk capital to an entity owned, directly or indirectly, by a connected person, other than the provision
of a loan. 5 Includes all of the following without limitations: (1) Significant shareholder; (2) Member of a board of directors or audit
committee; (3) Principal Officer and senior management officials; (4) Any person who is related to such significant
shareholder, member of the board of directors or audit committee, Principal Officer or senior management official by family
or business interest; (5) Subsidiary of a bank; (6) Company or undertaking in which at least a 5 percent interest is held by a
bank; (7) Parent company of a bank; (8) Company that is under common control with a bank; and (9) A company that holds
at least a 5 percent interest of another company in which a bank holds at least a 5 percent interest. 6 A contractual agreement where the right, or rights, to service an existing mortgage are sold by the original lender to another
party who specialises in the various functions of servicing mortgages. Common rights included are the right to collect
mortgage payments monthly, set aside taxes and insurance premiums in an escrow account6, and forward interest and principle
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(d) Aggregate investments by a bank or its subsidiary in the equity of other banks and
financial institutions, where the aggregate investment is equal to or greater than 10
percent of the capital of the institutions in which the investment is made. The
amount above the 10 percent threshold shall be deducted from CET1 capital, and
the amount below the threshold shall be appropriately risk-weighted. That is, the
excess above the 10 percent threshold must be deducted and the threshold amount
shall be risk-weighted as appropriate; and
(e) The amount of the three items (a,b,c) not deducted in the calculation of CET1
capital (threshold amounts) will be treated as other assets and risk-weighted at 250
percent.
Additional Tier I Capital of a Bank
2.7 Additional Tier I capital consists of the sum of the following elements:
(a) Instruments issued by a bank that meet the criteria for inclusion in Additional Tier
I capital (and are not included in CET1 capital);
(b) Share premium (stock surplus) resulting from the issue of instruments included in
Additional Tier I capital;
(c) Instruments issued by consolidated subsidiaries of a bank and held by third parties
that meet the criteria for inclusion in Additional Tier I capital, and are not included
in CET1 capital. Such instruments may receive recognition in Additional Tier I
capital of a bank, only if issued by a bank.
(d) Regulatory adjustments applied in the calculation of Additional Tier I capital.
Criteria for Classification as Additional Tier I Capital
2.8 For purposes of paragraph 2.7 above, qualifying instruments shall be subject to the
following conditions:
(a) Issued and paid-in;
(b) Subordinated to depositors, general creditors and subordinated debt of a bank;
(c) Is neither secured nor covered by a guarantee of the issuer or related entity, or other
arrangement that legally or economically enhances the seniority of the claim vis-à-
vis bank creditors;
(d) Is perpetual, i.e., there is no maturity date and there are no step-ups or other
incentives to redeem;
to the mortgage lender. Mortgage servicing may be performed by the original lender, or the lender may sell the right to service
a mortgage to another company, which performs the service for a fee.
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(e) May be callable at the initiative of the issuer only after a minimum of five years:
(i) To exercise a call option, a bank must receive prior supervisory approval;
and
(ii) A bank must not do anything which creates an expectation that the call will
be exercised;
(f) A bank must not exercise a call unless:
(i) It replaces the called instrument with capital of the same or better quality
and the replacement of this capital is done at conditions which are
sustainable for the income capacity of a bank7; or
(ii) A bank demonstrates that its capital position will be well above the
prescribed minimum capital requirement, following the exercise of the call
option.
(g) Any repayment of principal (e.g., through repurchase or redemption) must be with
prior supervisory approval and a bank should not assume or create market
expectations that supervisory approval will be given;
(h) Dividend/coupon discretion:
(i) The bank must have full discretion at all times to cancel
distributions/payments;
(ii) Cancellation of discretionary payments must not be an event of default;
(iii) A bank must have full access to cancelled payments to meet obligations as
they fall due; and
(iv) Cancellation of distributions/payments must not impose restrictions on a
bank, except in relation to distributions to common stockholders;
(i) Dividends/coupons must be paid out of distributable items;
(j) The instrument cannot have a credit sensitive dividend feature, that is, a
dividend/coupon that is reset periodically, based in whole or in part, on a bank’s
credit standing;
(k) The instrument cannot contribute to liabilities exceeding assets, if such statement
of financial position test forms part of national insolvency law;
(l) Instruments classified as liabilities for accounting purposes must have principal loss
absorption through either (i) conversion to common shares at an objective pre-
specified trigger point or (ii) a write-down mechanism which allocates losses to the
7 Replacement issues can be concurrent with, but not after the instrument is called.
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instrument at a pre-specified trigger point. The write-down will have the following
effects:
(i) Reduce the claim of the instrument in liquidation;
(ii) Reduce the amount re-paid when a call is exercised; and
(iii) Partially or fully reduce coupon/dividend payments on the instrument;
(m) Neither a bank nor a related party over which a bank exercises control or significant
influence can have purchased the instrument, nor can a bank directly or indirectly
have funded the purchase of the instrument;
(n) The instrument cannot have any features that hinder recapitalisation, such as
provisions that require the issuer to compensate investors if a new instrument is
issued at a lower price during a specified time frame; and
(o) If the instrument is not issued out of an operating entity or the holding company in
the consolidated group (e.g., a special purpose vehicle – “SPV”), proceeds must be
immediately available without limitation to an operating entity8 or the holding
company in the consolidated group, in a form which meets or exceeds all of the
other criteria for inclusion in Additional Tier I capital.
Regulatory Adjustments in Additional Tier I Capital
2.9 The following items shall be fully deducted from Additional Tier I Capital:
(a) Direct investments in own Additional Tier I capital, net of any short positions, if
the short positions involve no counterparty risk;
(b) Indirect investments in own Additional Tier I capital (e.g., through holdings of
index securities in which the bank itself is a constituent), net of any short positions;
(c) Any own Additional Tier I capital, which the bank could be contractually obliged
to purchase;
(d) Reciprocal cross holdings and the capital of banking, financial and insurance
entities that are outside the scope of regulatory consolidation9; and
(e) Significant investments in the capital of banking, financial and insurance entities
that are outside the scope of regulatory consolidation (i.e., where the bank owns
more than 10 percent of the issued common share capital or where the entity is an
affiliate).
8 An operating entity is an entity set up to conduct business with clients with the intention of earning a profit in its own right. 9 Holdings of Additional Tier 1 capital or similar instruments that are part of a reciprocal cross holding arrangement.
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Additional Tier I Capital Threshold Deductions
2.10 Instead of a full deduction, aggregate amount of non-significant investments in Additional
Tier I capital of unconsolidated financial institutions (banks, insurance and other financial
entities), shall receive limited recognition when calculating Additional Tier I capital, with
recognition capped at 10 percent of the bank’s common equity (after the application of all
regulatory adjustments set out under paragraph 2.9). That is, the excess above the 10
percent threshold must be deducted and the threshold amount shall be risk-weighted as
appropriate.
Tier II Capital (Gone-concern Capital)
2.11 Tier II Capital is capital that can absorb losses on a "gone-concern” basis, or capital that
absorbs losses in insolvency, before losses can be incurred by general creditors and
depositors. That is, it helps to ensure that general creditors and depositors get repaid if the
bank fails. It includes instruments issued by a bank that meet the criteria for inclusion in
Tier II Capital, general provisions and current year’s unpublished profits.
2.12 Tier II capital consists of the sum of the following elements:
(a) Instruments issued by a bank that meet the criteria for inclusion in Tier II capital
(and are not included in Tier I capital);
(b) Share premium (stock surplus) resulting from the issue of instruments included in
Tier II capital;
(c) Instruments issued by consolidated subsidiaries of a bank and held by third parties
that meet the criteria for inclusion in Tier II capital, and are not included in Tier I
capital (minority interests);
(d) General provisions/general loan loss reserves - Provisions or loan-loss reserves held
for future, presently unidentified losses, which are freely available to meet losses
which subsequently materialise. NB: Provisions ascribed to identified deterioration
of particular assets or known liabilities, whether individual or grouped, do not
qualify to be included in Tier II capital. Furthermore, general provisions/general
loan-loss reserves eligible for inclusion in Tier II capital will be limited to a
maximum of 1.25 percentage points of credit risk-weighted assets;
(e) Current year’s unpublished profits; and
(f) Regulatory adjustments applied in the calculation of Tier II Capital.
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Criteria for Inclusion in Tier II Capital
2.13 An instrument shall meet or exceed the following minimum set of criteria in order for it to
be included in Tier II capital:
(a) Issued and paid-in;
(b) Subordinated to depositors and general creditors of a bank;
(c) Is neither secured nor covered by a guarantee of the issuer or related entity or other
arrangement that legally or economically enhances the seniority of the claim vis-à-
vis depositors and general bank creditors;
(d) Maturity:
(i) Minimum original maturity of at least five years;
(ii) Recognition in regulatory capital in the remaining five years before maturity
will be amortised on a straight line basis. That is, during the last five years
to maturity, a cumulative discount factor (amortisation) of 20 percent
per annum will be applied to reflect the diminishing value of these
instruments as a continuing source of financial strength, and
(iii) There are no step-ups or other incentives to redeem.
(e) May be callable at the initiative of the issuer only after a minimum of five years:
(i) To exercise a call option, a bank must receive prior supervisory approval;
(ii) A bank must not do anything that creates an expectation that the call will be
exercised10;
(iii) A bank must not exercise a call unless:
It replaces the called instrument with capital of the same or better quality
and the replacement of this capital is done at conditions which are
sustainable for the income capacity of the bank11; or
A bank demonstrates that its capital position is well above the minimum
capital requirements after the call option is exercised12.
10 An option to call the instrument after five years, but prior to the start of the amortisation period, will not be viewed as an
incentive to redeem, as long as the bank does not do anything that creates an expectation that the call will be exercised at this
point.
11 Replacement issues can be concurrent with, but not after the instrument is called.
12 Minimum refers to the regulator’s prescribed minimum requirement, which may be higher than the Basel III Pillar 1
minimum requirement.
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(f) The investor must have no rights to accelerate the repayment of future scheduled
payments (coupon or principal), except in bankruptcy and liquidation;
(g) The instrument cannot have a credit sensitive dividend feature, that is a
dividend/coupon that is reset periodically based in whole or in part on the banking
organisation’s credit standing;
(h) Neither the bank nor a related party over which the bank exercises control or
significant influence can have purchased the instrument, nor can the bank directly
or indirectly have funded the purchase of the instrument; and
(i) If the instrument is not issued out of an operating entity or the holding company in
the consolidated group (eg a special purpose vehicle – “SPV”), proceeds must be
immediately available without limitation to an operating entity13 or the holding
company in the consolidated group in a form which meets or exceeds all of the
other criteria for inclusion in Tier II Capital.
Regulatory Adjustments in Tier II Capital
2.14 The following items shall be deducted in full from Tier II Capital:
(a) Direct investments in own Tier II capital, net of any short positions, if the short
positions involve no counterparty risk;
(b) Indirect investments in own Tier II Capital (e.g., through holdings of index
securities in which a bank itself is a constituent), net of any short positions;
(c) Any own Tier II capital, which the bank could be contractually obliged to purchase;
(d) Reciprocal cross holdings and the capital of banking, financial and insurance
entities that are outside the scope of regulatory consolidation; and
(e) Significant investments in the capital of banking, financial and insurance entities
that are outside the scope of regulatory consolidation (i.e., where a bank owns more
than 10 percent of the issued common share capital or where the entity is an
affiliate).
Tier II Capital Threshold Deductions
2.15 Instead of a full deduction, the aggregate amount of non-significant investments in Tier II
capital of unconsolidated financial institutions (banks, insurance and other financial
entities), shall receive limited recognition when calculating Tier II capital, with recognition
capped at 10 percent of the bank’s common equity (after the application of all regulatory
adjustments set out under paragraph 2.13). That is, the excess above 10 percent threshold
must be deducted and the threshold amount shall be risk-weighted as appropriate.
13 An operating entity is an entity set up to conduct business with clients with the intention of earning a profit in its own right.
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Capitalisation of Interim Profits
2.16 During the year, a bank licensed under the Act is authorised to capitalise its mid-year
audited interim profits, net of proposed interim dividends and an auditor’s certificate to
that effect must be issued.
2.17 It is expected that in deciding to capitalise half year’s net profits, a bank would take a
“whole year” view of the performance to avoid capitalisation of interim profits only to be
eroded by losses in the second half of the year.
2.18 A bank must notify Bank of Botswana of any subsequent dividend payout, which would
result in the reduction of the latest audited capital position of the institution.
Capital Adequacy Assessment
2.19 A bank shall be required to establish appropriate systems, which will enable them to
accurately determine the adequacy of its levels of capital, for the existing business risks.
Through its oversight function, a bank’s Board will also be expected to ensure that annual
tests to obtain independent assurance about the adequacy of a bank’s capital are carried
out. Furthermore, all banks must be able to demonstrate the adequacy of their capital bases
to the Bank, as may be required, either during an on-site examination and/or through the
off-site monitoring process, using statutory returns.
Provisions to be made for Certain Items
2.20 In accordance with Section 14 of the Act, in making any calculations necessary to ascertain
whether or not the capital of a bank is adequate for the purpose of complying with the
requirements of Section 13 of the Act, account shall be taken, to the satisfaction of the
Bank, and in accordance with International Financial Reporting Standards, of the following
items:
(i) collectively and individually assessed impairments for bad and doubtful debts;
(ii) depreciation of assets (to be calculated at least once in each financial year);
(iii) operating and accumulated losses;
(iv) preliminary expenses relating to the organisation or extension of the purchase of
any business or goodwill; and
(v) such other items as may be prescribed.
2.21 Each bank shall either:
(a) maintain a primary reserve account that is, in the opinion of the Bank, adequate,
and which is reserved exclusively for the purpose of making good any loss resulting
from the negligence or dishonesty of any director, principal officer or any other
officer or employee of the bank; or
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2.22 Subject to the minimum provisioning requirements set by the Bank and provisioning
methodology adopted by a bank, the Bank’s examination team shall assess the level and
adequacy of provisions for impairments based on the performance status of loans and
advances using a methodology determined by the Bank.
2.23 If the Bank concludes, based on its review of the reports of a bank or the results of an
examination of a bank, that the bank’s provisions for losses and impairments and other
items identified in Section 14 of the Act are inadequate to provide for the realistic
probability of loss or reduction, then the Bank may order the bank to establish additional
provisions for such losses and other items identified in Section 14 of the Act.
Transitional Arrangements
Non-qualifying Capital Instruments
2.24 A bank will phase out, over a period of five years, beginning January 1, 2016, capital
instruments that no longer qualify as Tier I capital or Tier II capital. Fixing the base at the
nominal amount of such outstanding instruments on January 1, 2016, their recognition will
be capped at 80 percent from January 1, 2016, with the cap reducing by 20 percentage
points in each subsequent year. This cap applies to each tier of capital separately and refers
to the total amount of outstanding instruments that no longer meet the relevant qualifying
criteria. To the extent that the instrument is redeemed, or its recognition in capital is
amortised, after January 1, 2016, the nominal amount serving as a base shall not reduced.
2.25 Only hybrid capital instruments issued before January 1, 2016 qualify for the above
transitional arrangements.
New Regulatory Adjustments
2.26 Regulatory adjustments introduced by the new rules (i.e., items not currently required to
be deducted in the existing capital framework), shall be gradually phased in over a period
of five years, beginning January 1, 2016. In particular, regulatory adjustments will begin
at 20 percent of the required adjustments to the relevant tier on January 1, 2016, 40 percent
on January 1, 2017, 60 percent on January 1, 2018, 80 percent on January 1, 2019 and 100
percent in January 1, 2020. During this transition period, the balance not deducted from
capital will continue to be subject to the existing treatment.
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3. MINIMUM CAPITAL ADEQUACY RATIO
3.1 Under the current Basel I capital structure, there are only two tiers of capital, namely, Tier
I Capital (core capital) and Tier II Capital (supplementary capital). While the Basel I
prudential minimum capital adequacy ratio of 15 percent is retained, under Basel II, (Table
1 below), the core capital element is further apportioned into two components, CET 1
Capital (4.5 percent) and Additional Tier I Capital (3 percent). In accordance with Section
13(6) of the Act, which prescribes that core capital shall constitute a minimum of 50 percent
of the total capital of a bank, the two constituents of core capital must be at least 7.5 percent
of the total risk-weighted assets of a bank. The remaining 7.5 percent of a bank’s risk-
weighted assets may either be in the form of eligible supplementary capital funds (Tier II
Capital) or Tier I Capital. That is, there is nothing that prevents any bank from holding all
or the majority of its capital as Tier I Capital.
Table 1: Capital Adequacy Requirements (Percent)
Common Equity
Tier1
Additional
Tier I
Tier I Capital Tier II
Capital
Total Capital
Prudential
Minimum
4.5
3
7.5
7.5
15
3.2 If, as a consequence of a review of capital adequacy, both with regard to risk assets and
other activities which entails risk, undertaken by the Bank as part of its examinations under
Section 24(1) of the Act, the Bank determines that the capital and reserves of a bank are
inadequate, the Bank may call for corrective measures as authorised by Section 27 (a) of
the Act.
3.3 Consistent with Section 13(2) of the Act, where a bank fails to maintain its unimpaired
capital at the level required in accordance with paragraph 3.1 above, the Bank may impose
on and collect from it a levy not exceeding 0.1 percent of the amount by which such
unimpaired capital falls short of the amount prescribed.
3.4 A bank’s audited financial statements and statutory returns should show the unimpaired
capital elements. Furthermore, the Bank’s on-site examination reports must include a page
measuring capital through the capital convergence method of risk-weighting for on-balance
and off-balance sheet items.
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4. PILLAR I: MINIMUM REGULATORY CAPITAL REQUIREMENTS
4.1 Under Pillar I of the Basel II framework, in addition to credit risk, a separate and explicit
computation of the regulatory capital for market risk and operational risk is introduced.
Therefore, the minimum amount of regulatory capital is derived through the summation of
capital charges for credit risk, operational risk and market risk. The computation of the
regulatory capital adequacy requirements by a bank shall be based on an approach
prescribed by the Bank for credit risk, market risk and operational risk. Where applicable,
capital charges for other types of risks not included in the calculation of the regulatory
capital adequacy ratio (e.g., liquidity risk, interest rate risk in the banking book, business
risk and credit concentration risk) shall be assessed under Pillar II.
4.2 Each bank shall compute its capital adequacy requirements based on the Standardised
Approach (SA) for credit risk, a choice between the Basic Indicator Approach (BIA) and
Standardised Approach (SA) for operational risk, and Standardised Measurement Method
(SMM) for market risk. These methods are explained in the Basel II document.
4.3 The formula for the computation of the regulatory capital adequacy ratio shall be:
CAR14 = UC/(RWA for CR + (Capital Charge for OR + Capital Charge for MR) * 6.7) * 100 ≥ 15 percent
It must be noted that the risk-weighted on- and off-balance sheet assets for credit risk will
be determined by multiplying the credit exposures by the appropriate risk-weights,
dependent on the counterparty’s risk rating, as applicable. However, the amount of the risk-
weighted assets for both operational risk and market risk shall be determined by
multiplying the respective capital requirements by 6.715, the result of which is added to the
risk-weighted assets for credit risk, to come up with the total risk-weighted assets of a bank.
(a) Capital Charge for Credit Risk: Standardised Approach
4.4 The computation of the credit risk capital charge of a given bank will be based on risk-
weights assigned for each borrower and other exposures (Appendix 1), on- and off-balance
sheet, calibrated by allowable credit risk mitigation techniques (CRMs). The SA (which is
closest to Basel I) is the simplest approach for calculating the capital charge for credit risk.
The main distinguishing factors of this approach, in comparison to Basel I, is that it is more
risk sensitive and counterparty risk-weights are based on external credit ratings. It also
entails eligibility and qualification criteria for different types of exposures and external
credit rating agencies. However, where external credit ratings do not exist for an exposure
(unrated), a bank must allocate a 100 percent risk-weight for such an exposure. This
approach also allows for the capital of a bank to be adjusted (reduced) by the amount of
the eligible CRMs (e.g., collateral in the form of cash or securities, third party guarantees,
14 Capital Adequacy Ratio (CAR); Unimpaired Capital (UC); Risk-weighted Assets (RWA); Credit Risk (CR); Operational
Risk (OR); Market Risk (MR). 15 The 6.7 is the inverse of the 15 percent prudential minimum CAR (1/0.15).
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derivative financial instruments and/or set-off/on-balance sheet netting of a loan by the
amount of deposit held by the bank for the same customer in the same currency).
4.5 The other major highlights of the SA approach for credit risk are the lower risk-weights for
qualifying retail exposures and residential mortgages. For example, under Basel I, all
unsecured private sector loans and advances (corporate and retail exposures) were assigned
a blanket risk-weight of 100 percent. Under the Basel II framework, retail exposures,
which meet the set qualifying criteria, are risk-weighted at 75 percent. Owner-occupied
residential mortgages or rented for residential purposes, meeting the set qualifying criteria,
are assigned a 35 percent risk-weight, compared to 50 percent under Basel I.
External Credit Assessment
4.6 For purposes of assigning risk-weights for claims on counterparties, a bank shall recognise
the ratings of Standard & Poors Ratings Services, Moodys Investors Service and Fitch
Ratings. The Bank shall also, at its discretion, recognise the ratings of any other external credit
assessment institution (ECAI) upon application by the ECAI, or the bank on behalf of the
ECAI, provided that they meet the eligibility criteria specified in the Basel II document.
4.7 A bank must use the chosen ECAIs and their ratings consistently for each type of claim,
for both risk-weighting and risk management purposes. A bank will not be allowed to
“cherry-pick” the assessments provided by different ECAIs. In the case of unrated
exposures, the applicable risk-weight shall be 100 percent or more, as may be prescribed
by the Bank from time to time.
4.8 A bank shall only be permitted to use solicited ratings.
4.9 External assessments for one entity within a corporate group cannot be used to risk-weight
other entities within the same group.
Multiple Assessments
4.10 If there are two assessments by ECAIs chosen by a bank, which map into different risk-
weights, the higher risk-weight will be applied.
4.11 If there are three or more assessments with different risk-weights, the assessments
corresponding to the two lowest risk-weights should be referred to and the higher of those
two risk-weights will be applied.
Domestic Currency and Foreign Currency Assessments
4.12 Where a borrower’s domestic currency ratings are separate from the foreign currency
ratings, a bank shall use a borrower’s domestic currency rating for exposures denominated
in domestic currency and foreign currency ratings for exposures denominated in foreign
currency. For example, for an exposure to a South African bank denominated in rand, use
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South Africa’s domestic/local currency rating; and for an exposure to a South African bank
denominated, say, in US dollars, use South Africa’s foreign currency rating.
4.13 For risk-weighting purposes, only long-term assessments shall be allowed in this capital
standard.
Criteria for Inclusion in the Regulatory Retail Portfolio
4.14 Claims that are included in the retail portfolio, which meet the qualifying criteria, shall
attract a risk-weight of 75 percent, except as provided under the paragraph for past due
loans (paragraph 4.18). Such claims must meet the following criteria:
(a) Orientation criterion: The exposure is to an individual person or persons or to a
small business;
(b) Product criterion: The exposure takes the form of any of the following: revolving
credits and lines of credit (including credit cards and overdrafts), personal term
loans and leases16 and small business17 facilities and commitments. Mortgage loans
and securities (such as bonds and equities) are excluded from this category;
(c) Granularity criterion: No aggregate exposure to one counterparty18 should be
allowed to exceed 0.2 percent of the overall retail portfolio;
(d) Low value of individual exposures: The maximum aggregated retail exposure to
one counterparty and groups of related counterparties must not exceed P10 million;
and
(e) Other retail portfolio not meeting any of the criteria under (a) to (d) above, will be
risk-weighted at 100 percent.
4.15 On an ongoing basis, the Bank will evaluate the risk-weights assigned to the retail portfolio
based on the default experience of these exposures and accordingly determine if these
exposures warrant a risk-weight higher than 75 percent. Where this discretion is executed
by the Bank of Botswana, it would apply to the banking industry as a whole.
16 A lease is a contractual arrangement calling for the lessee (user) to pay the lessor (owner) for use of an asset.
17 Small business classification should be done in relation to turnover/revenue per annum up to a maximum of P4 million (as
defined in the revised statutory returns). 18 Aggregate exposure means gross amount (i.e., not taking any credit risk mitigation into account) of all forms of debt exposures
(e.g., loans or commitments) that individually satisfy the three other criteria. In addition, “to one counterpart” means one or
several entities that may be considered as a single beneficiary (e.g., in the case of a small business that is affiliated to another
small business, the limit would apply to the bank’s aggregated exposure to both businesses).
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Criteria for Inclusion as Claims Secured by Residential Property (owner-occupied
residential mortgages)
4.16 Claims secured by residential property, up to P10 million or such other figure as may be
determined by the Bank from time to time, shall be risk-weighted at 35 percent, except as
set out at paragraph 4.18 of the Basel II document for past due loans. This preferential
risk-weight is subject to the following conditions:
(a) Lending must be fully-secured by mortgage on the financed residential property;
(b) The residential property must be owner-occupied or rented by the borrower to a
third party, but used for residential purposes;
(c) The residential property must be valued according to strict valuation rules19 and a
the bank must ensure that the value of the property is assessed at least once every
three years, or more frequently, if market conditions show signs of volatility;
(d) A bank must not only rely on the underlying property provided as collateral, but
rather on the borrower’s capacity to repay the debt from other sources;
(e) The property must be insured by a recognised third party insurer for fire and other
perils throughout the lifespan of the loan;
(f) The Loan-to-Value ratio20 must not exceed 90 percent. Where the LTV ratio
exceeds 90 percent, the excess shall be risk-weighted at 75 percent; and
(g) Other “owner-occupied)” residential property not meeting any of the criteria under
(a) to (e) above, will be risk-weighted at 75 percent.
4.17 On an ongoing basis, the Bank will evaluate the risk-weights assigned to claims secured
by residential property based on the default experience of these exposures and accordingly
determine if these exposures warrant a risk-weight higher than 35 percent. Where this
discretion is executed by the Bank of Botswana, it would apply to the banking industry as
a whole.
Treatment of Past Due Loans (more than 90 days, net of specific provisions)
4.18 For any unsecured portion of any loan (other than a qualifying residential mortgage loan)
that is past due for more than 90 days, net of specific provisions (including partial write-
offs), shall be assigned risk-weights in line with the table below:
19 The valuation should be carried out by accredited valuers who are members of the Real Estate Institute. This includes but is
not limited to a person who possesses the necessary qualifications, experience and is independent from the credit decision
process. 20 The loan-to-value ratio is defined as outstanding loan amount divided by the open market property value multiplied by 100.
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Specific Provision (SP) Risk-weight (Percent)
SP < 20 percent of outstanding loan amount 150
SP between 20 percent and 50 percent of outstanding loan
amount
100
For loans secured by residential property, where such loans
are past due for more than 90 days, and their SP < 20
percent
100
SP more than 50 percent of outstanding loan amount 50
For loans secured by residential property and SP is greater
than 20 percent of outstanding loan amount
50
Minimum Requirements for the Recognition of Credit Risk Mitigation (CRM)
Techniques
4.19 Consistent with the SA for credit risk, banks in Botswana will be permitted to take into
account CRMs, as shown in Appendix 2.
4.20 In order for a bank to obtain regulatory capital relief for the use of any CRM technique, the
following conditions shall be met:
4.21 A bank should meet the CRM disclosure requirements as detailed under Pillar III - Market
Discipline21;
4.22 All documentation used in collateralised transactions and for documenting on-balance
sheet netting, guarantees and credit derivatives, must be binding on all parties and legally
enforceable in all relevant jurisdictions. A bank must have undertaken sufficient legal
review to verify this and have a sound legal basis to reach this conclusion, and undertake
such further reviews as necessary to ensure ongoing enforceability;
4.23 The legal mechanism by which collateral is pledged or transferred must ensure that a bank
has the right to liquidate or take legal possession of it, in a timely manner, in the event of
default, insolvency or bankruptcy of the counterparty (and where applicable, take legal
action on the custodian holding the collateral or legal possession of collateral);
4.24 A bank shall take all steps necessary to fulfill those requirements under the law applicable
to a bank’s interest in the collateral for obtaining and maintaining an enforceable security
interest, i.e., by registering it or for exercising a right to net or set-off in relation to title
transfer collateral (see Appendix 3 for legal criteria and bilateral netting rules);
4.25 In order for collateral to provide protection, the credit quality of the counterparty and the
value of the collateral must not have a material positive correlation. For example, securities
issued by the counterparty, or by any related group entity, would provide little protection
and so would be ineligible;
21 See Basel II document
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4.26 A bank must have clear and robust procedures for the timely liquidation of collateral to
ensure that any legal conditions required for declaring the default of the counterparty and
liquidating the collateral are observed and that the collateral can be liquidated promptly;
4.27 Where the collateral is held by an independent custodian or an equally independent third
party, a bank must take reasonable steps to ensure that the custodian segregates the
collateral from its own assets;
4.28 When cash on deposit, certificates of deposit or comparable instruments issued by a lending
bank are held as collateral at a third-party bank, in a non-custodial arrangement, if they are
openly pledged/assigned to a lending bank, and if the pledge/assignment is unconditional
and irrevocable, the exposure amount covered by the collateral (after any necessary
haircuts for currency risk), will receive the risk-weight of the third-party bank;
4.29 A capital requirement will be applied to a bank on either side of the collateralised
transaction: For example, both repos and reverse repos will be subject to capital
requirements. Likewise, both sides of a securities lending and borrowing transaction will
be subject to explicit capital charges, as will the posting of securities in connection with a
derivative exposure or other borrowing and;
4.30 Where a bank, acting as an agent, arranges a repo-style transaction (i.e., repurchase/reverse
repurchase and securities lending/borrowing transactions) between a customer and a third
party, and provides a guarantee to a customer that the third party will perform on its
obligations, then the risk to a bank is the same as if the bank had entered into the transaction
as a principal. In such circumstances, a bank shall be required to calculate capital
requirements as if it were itself the principal.
CRM Approaches22
4.31 A bank shall select one, but not both of the following approaches, and apply that approach
to its entire on- and off-balance sheet banking book exposures that are subject to credit risk
mitigation:
(a) The Simple Approach; or
(b) The Comprehensive Approach to credit risk mitigation.
4.32 A bank shall advise the Bank, which of the above CRM approaches it has chosen to use for
its banking book exposures. With respect to trading book exposures, only the
Comprehensive Approach will be allowed.
4.33 A bank shall also use the Comprehensive Approach to calculate the counterparty risk
charges for over-the-counter (OTC) derivatives and repo-style transactions in the trading
book.
22 See Basel II document
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4.34 Partial collateralisation shall be recognised in both approaches.
4.35 Mismatches in the maturity23of the underlying exposure and the collateral shall only be
allowed under the Comprehensive Approach.
4.36 Where there is a maturity mismatch and the CRM has an original maturity of less than one
year, the CRM is not recognised for regulatory capital purposes, i.e., hedges with maturity
mismatches will only be recognised when their original maturities are greater than or equal
to one year. In addition, partial recognition for maturity mismatches shall be given to the
CRM for regulatory capital purposes.
(b) Capital Charge for Operational Risk24
4.37 The new capital framework has introduced a separate capital charge for operational risk
using either the Basic Indicator Approach, Standardised Approach or Advanced
Measurement Approaches (AMA). In Botswana, banks will be permitted to use either the
BIA or SA. The use of SA by a bank is subject to prior approval by the Bank, while the
BIA is the default entry approach for all banks. For both approaches, gross profit is used
as a proxy for the computation of the operational risk capital charge.
(c) Capital Charge for Market Risk25
4.38 The capital charge for market risk shall be computed using the SMM. Banks are required
to assess, measure and apply capital charges in respect of market risk in the trading book;
this section does not apply to the banking book. For purposes of this framework, risks
subject to this requirement are those arising from interest rate related instruments, foreign
exchange risk, commodities risk and equity positions risk.
23 For the purpose of calculating risk-weighted assets, a maturity mismatch occurs when the residual maturity of a hedge
is less than that of the underlying exposure.
24 See Basel II document for computation. 25 See Basel II document for computation.
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5. PILLAR II: THE SUPERVISORY REVIEW PROCESS26
5.1 Pillar II - the Supervisory Review Process (SRP), aims to ensure that a bank has adequate
capital to support its operations at all times. It also promotes the adoption of a more forward
looking approach to capital management. In addition, it covers capital for other risks not
fully captured or factors not taken into account under Pillar I (concentration risk, interest
rate risk in the banking book and liquidity risk), factors external to a bank (business cycle
effects) and encourages a bank to develop and employ more rigorous risk management
techniques. Furthermore, Pillar II requires a bank to always operate above the prescribed
minimum prudential capital requirements. Thus, the underlying aim of the SRP is to
enhance the link between a bank’s risk profile, its risk management systems and capital, at
all times. Banking supervisory authorities are required to assess and take appropriate
action to ensure that the risk-based capital management of any bank is robust and effective.
5.2 The SRP has four principles, namely that:
(i) Banks should have processes for assessing the adequacy of capital in relation to
their risk profiles, commonly referred to as the Internal Capital Adequacy
Assessment Process (ICAAP);
(ii) The supervisory authority should review and evaluate banks’ internal capital
adequacy assessments and strategies; (iii) The supervisory authority should expect banks to operate above the regulatory
minimum capital requirements, where the minimum statutory requirement is the
floor;
5.3 The supervisory authority must intervene, at an early stage, and take remedial action to
prevent capital falling below minimum levels required to support the risk characteristics of
a particular bank. This implies that the supervisory authority must have highly skilled and
knowledgeable staff members to be able to provide the required guidance to banks and
ensure that their internal capital assessments are comprehensive and proportionate to the
nature and scale of the business operations of a particular bank.
5.4 Every bank is required to ensure that, at all times, it manages its capital over a planning
horizon of at most three years. The capital planning process must be dynamic and forward-
looking in relation to a bank’s risk profile. A bank should, therefore, ensure that capital
levels remain above the minimum regulatory capital requirements, as well as the capital
required to support its overall risk profile. The size of the required additional capital should
take into account current and anticipated changes in a bank’s risk profile and business plan
and/or strategy. A bank should also be cognisant of the stage of the business cycle in which
it is operating, given the potential changes in the external environment. Therefore, rigorous
and forward-looking stress testing should form an integral part of a bank’s ICAAP.
26 See Basel II document.
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Directive on the Revised International Convergence of Capital Measurement and Capital Standards for Botswana (Basel II)
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APPENDICES
Directive on the Revised International Convergence of Capital Measurement and Capital Standards for Botswana (Basel II)
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Appendix 1
(a) Summary of Risk-weights under Standardised Approach for Credit Risk
Credit Rate
Claims on Exposure
AAA to
AA-
A+
to A-
BBB+ to
BBB-
BBB+ to
B-
Below
B-/BB
Unrated
Risk-Weight /
CCF percentage
Government of Botswana and Bank of
Botswana
0
Cash 0
Cash items in the process of collection 20
Sovereigns and Central Banks 0 20 50 100 150 100
Bank for International Settlements,
IMF
0
Domestic Public Sector Entities 20
Foreign Public Sector Entities 20 50 100 100 150 100
Domestic banks 20
Foreign banks 20 50 100 100 150 100
Security firms 20 50 100 100 150 100
Eligible Retail 75
Other retail 100.
Mortgages27 35
Corporates /insurance companies 20 50 100 100 150 100 100
Multilateral Development Banks 20 50 50 100 150 50 0/100
Commercial Real Estate 100 100 100 100 100 100 100
Other Assets28 100
Off-balance Sheet Items CCF as approved
by central bank
Past Due Items 100(20); 100(20);
150(20)
Other Non-Qualifying Residential
Property
75
Investments in equity and regulatory
capital instruments issued by
unconsolidated financial institutions
250
Mortgage Servicing Rights 250
Deferred Tax Assets 250
Investments in commercial entities 1250
Venture capital and private equity
investment
150
27 Owner occupied or rented by the borrower to a third party but used for residential purposes 28 Excludes cash items in the process of collection
Directive on the Revised International Convergence of Capital Measurement and Capital Standards for Botswana (Basel II)
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(b) Credit Conversion Factors: Off-balance Sheet Items
Maturity/Commitment Credit Conversion Factor (CCF)
Percentage
Commitments:
Original maturity up to 1 year
Original maturity over 1 year
Unconditionally cancellable commitments without notice
20
50
0
Direct credit substitutes:
Acceptances and endorsements
Guarantees on behalf of customers
Letter of credit issued by the bank with no title to underlying shipment;
Letter of credit confirmed by the bank; and Standby letters of credit serving
as financial guarantee
100
Repo style transactions:
Sales and repurchase agreements and asset sales with recourse, where the
credit risk remains with the bank.
100
Lending of banks securities or posting of securities as collateral:
Repurchase/reverse repurchase agreements and securities/borrowing
transactions.
100
Forward asset purchases:
Commitment to purchase at a specified future date on prearranged terms, a
loan, security or other asset from another party, including written put options
on specified assets with the character or a credit enhancement.
100
Placements of forward deposits:
An agreement between a bank and another party where the bank will place a
deposit at an agreed rate of interest at a predetermined future date.
100
Partly paid shares and securities:
Amounts owing on the uncalled portion of partly paid shares and securities
held by a bank representing commitments with certain draw down conditions
by the issuer at a future date.
100
Certain transaction related contingent items:
Performance bonds, warranties and indemnities
Bid or tender bonds;
Advance payment guarantees;
Customs and excise bonds;
Standby letter of credit related to particular contracts and non-financial
transactions.
50
Note issuance facilities and revolving underwriting securities:
An arrangement whereby a borrower may draw down funds up to a
prescribed limit over a predetermined period by making repeated note issues
to the market. If the issue is unable to be placed in the market, the unplaced
amount is to be taken up or funds made available by a bank being committed
as an underwriter of the facility.
50
Short-term self-liquidating trade LCs/Trade related contingent items with an
original maturity below 6 months:
These are contingent liabilities arising from trade-related obligations,
secured against an underlying shipment of goods for both issuing and
confirming bank.
20
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Appendix 2
Eligible Collateral for Credit Risk
Eligible Collateral Under the Simple Approach
Cash (including CoDs) deposit with the bank which is incurring the counterparty exposure or similar products issues by the lending
bank.
Debt securities rated by a recognised external credit assessment institution where either:
At least BB- if issued by sovereigns or PSEs that are treated as sovereigns;
At least BBB- if issued by other entities, including banks and securities firms; or
At least A-3/P-3 for short-term debt instruments.
Securities that are issued by:
Government of Botswana (Treasury bills, bonds)
Bank of Botswana (Bills)
Debt securities not rated by a recognised external credit assessment institution where these are:
Issued by a bank;
Listed on recognised stock exchange;
Classified as senior debt;
All rated issues of the same seniority by the issuing bank must be rated at least BBB-/P-3 by a recognised credit assessment
institution; and
The bank holding the debt has no information that suggests that the debt security justifies a rating below the above level.
Bank of Botswana approval must be sought before recognising these as eligible collateral.
Undertakings for Collective Investment in Transferable Securities (UCITS) and mutual funds where:
A price for the units is publicly quoted daily; and
The UCITS/mutual fund is limited to investing in instruments listed above.
Equities (including convertible bonds) included in a main index
Eligible Collateral Under the Comprehensive Approach
All of the instruments in Eligible Collateral Under The Simple Approach;
Equities (including convertible bonds) which are not included in a main index but which are listed on a recognized exchange;
UCITS/mutual funds which include such equities.
Eligible Guarantors/Protection Providers for Credit Risk
1. Sovereigns29, PSEs, banks30 and security firms with a risk-weight of 20 percent or better and a lower risk-weight than the
counterparty.
2. Other entities rated A- or better. This would include credit protection provided by parent, subsidiary and affiliate companies
when they have a lower risk weight than the obligor.
29 This includes the Bank for International Settlements, the International Monetary Fund, the European Central
Bank and the European Community, as well as those MDBs currently eligible for a 0 percent risk weight. 30 This includes other MDBs.
Directive on the Revised International Convergence of Capital Measurement and Capital Standards for Botswana (Basel II)
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Appendix 3
The Legal Criteria for Netting Arrangements and Bilateral Netting Rules
(Set-off Principle)
To get approval for netting arrangements, a bank must satisfy the Bank that:
(i) it has executed a written, bilateral netting agreement with the counterparty that creates a
single legal obligation, covering all included bilateral master agreements and transactions,
such that a bank would have either a claim to receive or obligation to pay only the net sum
of the positive and negative (a) closeout values of any included individual master
agreements and (b) marked-to-market values of any included individual transactions, in the
event a counterparty fails to perform due to any of the following: default, bankruptcy,
liquidation or similar circumstances;
(ii) it has written and reasoned legal opinions31 that conclude, with a high degree of certainty
that, in the event of a legal challenge, relevant courts or administrative authorities would
find a bank’s exposure under the Netting Arrangement to be the net amount under the laws
of Botswana. In reaching this conclusion, legal opinions must address the validity and
enforceability of the entire Netting Arrangement under its terms and the impact of the
Netting Arrangement on the material provisions of any included bilateral master
arrangement;
(iii) it has internal procedures to verify that, prior to including a transaction in a netting set, the
transaction is covered by the legal opinions that meet the above criteria;
(iv) the bank undertakes to update the legal opinions, as necessary, to ensure continuing
enforceability of the Netting Arrangement, in light of possible changes in the relevant law;
(v) the Netting Arrangement does not include a walkaway clause. A walkaway clause is a
provision which permits a non-defaulting counterparty to make only limited payments, or
no payment at all, to the estate of the defaulter, even if a defaulter is a net creditor;
(vi) both transactions (debit and credit balances) must be denominated in the same currency;
(vii) counterparty(ies) prompting the debit and credit balances (netting) must have local resident
status;
(viii) deposits must be blocked until the liability (loan) is fully discharged;
(ix) the accounts can only be off-set against each other provided that the account is held in the
same right. Thus, a bank cannot set-off a debit balance against a credit balance of a
31 A legal opinion must be generally recognised as such by the legal community in the firm’s home country or a memorandum of
law that addresses all relevant issues in a reasoned manner.
Directive on the Revised International Convergence of Capital Measurement and Capital Standards for Botswana (Basel II)
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customer which, to the banker’s knowledge, is held in a representative or fiduciary capacity
or for a special purpose;
(x) each included bilateral master agreement and transaction included in the Netting
Arrangement satisfies applicable legal requirements for recognition of bilateral netting of
derivative contracts in the main text;
(xi) a bank maintains all the required documentation in its files; and
(xii) the net position will be used in assessing compliance with the capital adequacy
requirements only. Primary and liquidity reserve requirements, as well as the level of
provisions, should be assessed on the basis of the actual balances. However, where money
in a fixed deposit account is pledged as a security, the amount of this cash security will
continue to be deducted from the amount of loans, before determining the required level of
specific provisions.